The European Recovery: Here to Stay?

Economic Growth Outlook

• Euro Area 2021 GDP growth forecast at 5.4% (significantly above consensus).
• UK 2021 GDP growth forecast at 8.1% (significantly above consensus).
• Growth momentum expected to accelerate through summer due to declining hospitalizations and a sharp rise in vaccinations.
• Targeting 50% of the Euro Area population fully vaccinated by late June.
• Services sector activity is projected to surge as restrictions lift, unlocking pent-up demand after remaining depressed during the pandemic.
• Manufacturing activity has already normalized, supported by firm demand from the US and China.
• Fiscal stance expected to remain expansionary across the Euro Area, adding ~1.5 percentage points to growth in 2021 and 0.5 percentage points in 2022.

Fiscal Policy and Recovery Fund

• EU Recovery Fund ratified and actively disbursing debt-funded grants and loans.
• Southern European nations (e.g., Italy, Spain) allocated approximately 12% of GDP from the fund over the coming years.
• Funds are targeted toward public investment projects and structural reforms with high economic multipliers.
• National deficits are expected to shrink gradually starting in 2022, avoiding the premature consolidation seen post-2008.
• Recovery fund support is persistent through 2026, distinguishing it from the one-off nature of previous crisis responses.

Monetary Policy and Inflation

• ECB maintained the pace of asset purchases (PEP program) but signaled a slight seasonal reduction in August due to lower issuance.
• ECB upgraded growth outlook, describing economic risks as "balanced" for the first time since December 2018.
• ECB kept the 2023 headline inflation forecast unchanged at 1.4%, well below the 2% target.
• ECB President Lagarde stated that discussions on exiting accommodative policy are "premature and unnecessary."
• Goldman Sachs forecasts no ECB rate hike until 2025.
• Current inflation spike attributed to temporary factors: commodity prices, base effects from 2020, and technical tax changes.
• German headline inflation projected to peak at 4% in November 2021 before declining as temporary factors dissipate.
• Sustainable core inflation trend remains low at approximately 1%, with a gradual rise to 1.5% expected by end of 2024.

Market Performance and Flows

• Stoxx Europe 600 (SX5E) has outperformed the S&P 500 and NASDAQ year-to-date for the first time in years.
• Rally driven by cyclical sectors: banking and autos up nearly 30% each; defensive sectors like utilities remain flat.
• Investor flows show 10 out of 11 weeks of inflows into Europe, indicating a shift from defensive to cyclical positioning.
• Prime brokerage data indicates European positioning has improved from a -4 baseline to a moderate long bias of +1 to +3.
• Substantial appetite for Southern Europe equities, particularly Italy, fueled by Recovery Fund allocations and structural reform prospects.
• European geography remains a relative underweight in client portfolios compared to the US, suggesting room for further inflows.

Risks and Forward-Looking Considerations

• Variant Risk: Delta variant concerns persist, particularly in the UK, but are viewed as manageable risks if vaccination continues.
• Political Risks:
  • Italy: Presidential election in February; potential political rift if Draghi steps down or if a coalition forms against the current leadership.
  • France: Upcoming elections pose tail risk; most serious scenario involves a left-wing coalition facing Marine Le Pen in the first round, ousting Macron.
  • Germany: September election could impact bond markets depending on the "Greens" share and future deficit expansion rules.
• Structural Narrative: A potential shift from a disinflationary narrative to one favoring rising interest rates and value stocks, benefiting European banks and the broader economy.
• Reversal Risk: Future pivot to austerity or fiscal consolidation could reignite sovereign crisis dynamics seen in the early 2010s.
• Investment Horizon: Market optimism is currently driven by short-term recovery momentum, though structural arguments regarding fiscal integration and reforms offer longer-term support.